A collection of observations, news and resources on the changing nature of innovation, technology, leadership, and other subjects.

July 30, 2018

The Emergence of a Blockchain-Based Token Economy

Blockchain Revolution, published in May of 2016 by Don Tapscott and Alex Tapscott, was one of the first books that explained the promise of blockchain technologies to the general public. Its central argument is that for nearly four decades, the Internet has been great for reducing the costs of searching, collaborating, and exchanging information.But, it has serious limitations for business and economic activity.“Doing business on the Internet requires a leap of faith,” the book noted.The Internet was designed to move information, but it’s lacked the necessary trust, security and privacy safeguards to move assets of value.With blockchain, we’re now seeing the emergence of such an Internet of value.“Now for the first time ever we have a native digital medium for value, through which we can manage, store, and transfer any asset.”

An updated edition of Blockchain Revolution was published this past June. A lot has happened with blockchain in the intervening two years.The updated edition explains some of these recent developments in a new preface, including cryptoassets, permissioned networks, identity and supply chains.I’ll focus my comments on the emergence of a blockchain-based token economy, driven by the explosive growth in the value and variety of cryptoassets.

When the original book was published, the entire cryptoasset market had a value of $9 billion, - mostly dominated by the value of Bitcoin at $7 billions, while Ether, the Ethereum cryptocurreny, had reached around $1 billion.The new edition estimates that as of March, 2018, the cryptoasset market was around $400 billion in size, a value subject to rapid fluctuations.In addition, a wide variety of cryptoassets have been developed over the past two years.

The book lists several different types of cryptoassets: cryptocurrencies, platforms, security tokens, natural asset tokens, stablecoins, utility tokens, crypto collectives, and crypto fiat currencies Let me say a few words about the first five.

Cryptocurrencies.“Bitcoin is the workhorse of the cryptocurrency world and the cryptocurrency that launched a thousand ships.”In only a decade, bitcoin has become a secure, decentralized payment system that requires no trusted intermediary; a store of value now worth hundreds of billions of dollars, and, potentially, a reserve currency for the fast growing global cryptoasset market.

Platforms.Blockchain platforms are designed to enable the development of distributed applications based on the concept of smart contracts, which are essentially software programs that mimic the logic of a business agreement.Running as part of blockchains, smart contracts significantly reduce the need for intermediaries, - e.g., banks, brokers, lawyers, escrow agents, - to guarantee execution.Ethereum is the leading blockchain-based platform technology, which has boosted the value of its associated Ether cryptocurrency.

Security tokens.Initial Coin Offerings (ICOs) have emerged as a means of raising capital for startup projects by going directly to investors, thus avoiding the costs and delays of dealing with the regulatory compliance of traditional intermediaries like VCs, banks and stock exchanges.ICOs democratize the ability of projects to crowdfund themselves by issuing tokenized securities, but their current lack of regulations increases the risks to investors.While lots of questions remain, “ICOs have already upended venture capital.Wall Street could be next.”

Natural asset tokens.In much the way that financial assets can be tokenized, one can tokenize real-world physical assets, including carbon, clean air and water.Such natural assets are essential for life on earth and foundational to the economy, but they’ve largely remained immune from market-based forces.“This has led to overuse and exploitation of these resources, with costs borne by society in the form of what economists call negative externalities.”The result has been what’s commonly referred to as the tragedy of the commons, - a situation where individual users, only focus on their own self-interests, behave contrary to the common good by depleting or spoiling a shared resource because there’s no system to govern its use or consumption.The token economy could help us address the tragedy of the commons by aligning incentives with a common and collective goal, such as reducing carbon emissions.

Stablecoins.Bitcoin and similar cryptocurrencies have been generally quite volatile, - partly because they’re not backed by real-world assets.But this is not a property of cryptoassets in general.It’s possible to design cryptocurrencies whose overriding objective is to maintain the same value over time by pegging themselves to some underlying assets, be they fiat currencies or physical assets.

An example of such a stablecoin is the asset-backed Digital Trade Coin (DTC), a reserve currency being developed as part of MIT’s Connection Science initiative.As described in this recent paper, blockchain technologies are giving the old notion of asset-backed currencies a new lease of life.The paper “outlines an approach to building a consortium of sponsors, who contribute real assets, a narrow bank handling financial transactions involving fiat currencies, and an administrator, who issues the corresponding digital token in exchange for fiat payments and makes fiat payments in exchange for digital tokens.”

DTC aims to become “a transactional tool for a large pool of potential users, including small and medium enterprises (SME) and individuals,” as well as “a supranational digital token, which is insulated from adverse actions by central banks and other parties, due to the fact that it is asset-backed.”Its developers believe that DTC “is ideally suited as a medium of exchange for groups of smaller nations or supranational organizations, who wish to use it a counterweight to large reserve currencies.”

What does this all mean? The question was recently addressed in Why Blockchain Isn’t a Revolution, by U of Penn’s Wharton School professor Kevin Werbach.His article contrasts three different technologies that are often used interchangeably: cryptocurrencies, cryptoassets, and blockchain. “The first truly is a revolutionary concept, but the jury is still out on whether the revolution will succeed,” writes Werbach.“The second and third are game-changing innovations on the path to significant adoption, which are nonetheless essentially evolutionary.

Cryptocurrency: the idea that networks can securely transfer value without central points of control. “Bitcoin showed that something valuable - money - could be trusted without trusting anyone in particular to verify transactions.The idea, if brought to full fruition (and that’s a huge “if”), could transform society…Cryptocurrencies have the most disruptive potential, because they promise to decentralize power. That also creates the biggest barriers to success.”

Cryptoassets: the idea that virtual currencies can be financialized into tradable assets. “Cryptoassets take cryptocurrency tokens, turn them into instruments of trading, and spin ever more complex financial instruments out of the threads they produce.The potential scale is immense, with trillion-dollar markets not that unusual in modern finance.Where this effort diverges from the first is that it views cryptocurrencies not as a way to facilitate activities without centralized trust, but as a new investment asset class.Because they are natively digital, cryptoassets can in theory be traded more efficiently than existing instruments.”

Blockchain: the idea that networks can collectively reach consensus about information across trust boundaries.“A significant chunk of the transaction costs between firms (and sometimes within them) flow from the limited elasticity of trust.If every party to a transaction trusted the information involved, even though they didn’t trust one another, costs could fall and performance could improve drastically. That is the essence of the blockchain vision.Trusting your own records on a blockchain is tantamount to trusting everyone else’s records, because those records are one and the same.”

I agree with Werbach’s points.Bitcoin and similar cryptocurrencies really feel new and revolutionary, while cryptoassets like ICOs and DTC feel more like an efficient evolution of what financial markets have long been doing, which is why institutional investors and Wall Street are eager to get in on the action.Similarly, blockchain or distributed ledger technologies promise to significantly improve the efficiency of applications involving multiple institutions, - like global supply chains, - an important but evolutionary step akin to the impact that business process reengineering and enterprise resource planning (ERP) applications had in improving the efficiency of applications within a firm.

Whether revolutionary or evolutionary, these technologies promise to disrupt business models and transform industries and economies, but much work remains ahead to turn the promise into reality.